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Economic And Real Estate Investment Factors Affecting Our Decisions Don’t Exist In A Vacuum

by Jeff Brown on July 22, 2014 · 2 comments

  
Economic And Real Estate Investment Factors Affecting Our Decisions

Interest rates, unemployment, inflation, supply/demand, and a ton more, are factors affecting bazillions of daily decisions made by families, businesses of all sizes and in all industries.

We spend countless hours attempting to figure out their impact on what we’d like to do, or even more immediately urgent, what we’ve already done. Thing is, those factors are much akin to the differing ‘chemistry’ generated by altering sports teams’ lineups. Different players work better with one lineup vs another.

This is often true even when the skill level of a player left out is significantly superior to all of those in the new lineup. We can call it chemistry, synergy, sometimes even, forgive me, style of play. But we sports fans have all seen teams win more games as a result of what’s come to be called, ‘addition by subtraction’.

Let’s Jump Right In and Talk About One of Those Factors: inflation

The good thing about inflation, as long as it isn’t the runaway sort, is that real estate tends to track with it, more or less.

This has proven true not only with its value, but with income as well. On its face that is a giant plus, as we realize inflation in general eats away our overall buying power. But how long does it remain our buddy? From experience I can tell you the ride is both exhilarating and terrifying.

We love the increases in value and NOI (net operating income), especially when our loan is a relatively low, fixed rate. What we don’t love is the other edge of that same sword. It affects our buy side decisions, often to the point of retiring to the sidelines.

Related: Examining Real Estate and Inflation on a Global Perspective

Imagine buying a duplex at roughly 8-10 X the GSI (gross scheduled income/yr) using a fixed rate loan. Inflation hits and you’re showin’ off that smug smile we often have when we beat the odds. Fast forward a few short years and your duplex is now sellin’ for roughly 20-22 X GSI.

Only the last suckers on the bus are buyin’ those, right? Which also means you can do the HappyDance all ya want about its ‘market’ value, but you’re not gonna be sellin’ it any time soon, unless there’s a SuckersAreUs website out there. See? Now inflation isn’t your good buddy.

I get it that your cash flow may indeed be growing like a weed, and that’s hardly ever a downer. But if your Purposeful Plan was to sell/trade into an improved position, guess what? The hurry up ‘n wait plane is ready to board, and you’re in first class. ;)

How to Make Inflation your Friend, Regardless of its Tendency to Betray

Can we begin by unanimously agreeing that none of us has a crystal ball worth a used Snickers Bar?

AND, that predicting the future based upon what appears to be a clone-like past, is a proven way to turn a large fortune into a small one? That one lesson was what saved my bacon during the Mother of all Bubbles recently.

BawldGuy Axiom: We must default to the assumption that what seems like what happened back in the day, isn’t what’s happening now. Though our research may show otherwise, blindly assuming it’s exactly the same with the predictably identical results, will too frequently leave us wounded and bewildered. 

In my experience there’s been just a precious few ways a long term real estate/note investor can profit via inflation. Here are just three.

1. The most obvious is to acquire the investment before or very shortly after you perceive the inflation in prices and rents to have begun. Simply buy as much as you can conservatively afford, take care to nurse your overly generous cash reserves, then go fishing.

Related: Inflation Is The Real Estate Investor’s Best Friend.

2. If you’re a big wage earner, and we’ll define that as $150,000 or more in household income, you can build in a 3-5 year plan calling for you to eliminate your loan(s) while allowing you to sell, but with 0-50% of the normal tax liability that goes with that. You’ll end up with the spoils of inflation in your bank account without paying nearly the taxes you might have. At that point you can alter the vehicles you then acquire, or simply do what #1 above did, which is go fishing ’til things begin to look fun again. Bottom line is that this approach allows you to pull out gains without the taxman completely havin’ his way with ya.

3. This is a bit like #2, but you’re not lookin’ to sell. You would pay it off though in the same time span. This would be cool, if for no other reason than adding multiple new options to your menu. One of those would be to refinance at say, 70% LTV (loan to value), getting a buncha cash out, without tax consequences for the vast majority of investors. You’d then take that tax free loot to either invest in notes or some other vehicle that might yield tax free income in retirement. This one is incredibly effective as you’ve kept your real estate, it’s still cash flowing, though much less, and you’ve possibly created a new and stand alone source of retirement income.

The Perfect Storm that Must Be Watched like a Hawk

We must never stop our vigilance when the supply/demand curve benefits us as owners of the newly popular asset.

This is almost infinitely more consequential when supply/demand teams up with inflation. At that point those holding the supply often as not mistake their sudden popularity as indicating their ultimate strategy(s) are proving them to be prophets. I’ve made that mistake, much to my embarrassment. It also negatively impacted my bank account for a long time.

What makes this so-called perfect storm even more powerful is the existence of historically low interest rates. Add to this mix the investor’s ability to buy in exceptionally high quality locations sporting attractive rent/price ratios, and at times even I’ve had to pinch myself to remain focused on reality. All these cool factors combine to create not only a perfect storm, but the most powerful one I’ve witnessed as a pro, and this with almost 45 years in the biz. I’ve not seen these factors come together — never, ever.

BawldGuy Axiom: The chart’s direction goes both ways, up and down. Don’t make the common mistake of assuming a current trend will remain in tact interminably. With priceless few exceptions, that viewpoint will end up ruining your day — or the next 10,000 days.

The bazillion dollar question: How long ’til this particular perfect storm turns on us?

Man, I barely have a clue — and contrary to what many out there seem to believe, they don’t either. We’re all using empirical evidence to predict the future, which when it comes to timing, is the worst joke of all. Look, many of us have had a fairly good batting average, relatively speaking, when predicting what we THOUGHT was gonna happen. Though certainly not easy, experience, mind numbing research, and the ability to objectively analyze evidence based data, can make anyone look as if their crystal ball’s the only one without a crack.

The real trick is coming up with the accurate timing. History tells us that’s only for the foolish or narcissistic to take on. Though many predicted the bubble burst, nobody I know pinpointed the quarter, even the year. Many claim to, but I’m, shall we say, skeptical. I predicted the burst myself. In fact, not knowing the timing I then abandoned my hometown market, putting my future where my mouth was. The crash didn’t occur for almost another four years. And there ya go.

Frankly, I Think We’re likely good ’til the End of 2016.

That prediction, along with a $10 bill will get us both some coffee and a cookie. That’s the value I attach to it. It could happen next month, or next decade for all I know. What I do know, is that this perfect storm will turn on us when we’re happily sipping umbrella drinks in calm waters. It almost always works that way, right?

The Takeaway

Though I still strongly recommend the acquisition of high quality location properties in states with the right attitude towards investment capital, income taxes, and business, at some point we’re gonna find ourselves discussing the best lures for our next fishin’ trip.

Lock in the low interest rates ’til ya run outa capital, except for a far too generous cash reserve account. Buy discounted notes ’til ya puke. ;) Sometime in the next 10 years we’re gonna be braggin’ ’bout our genius investments, bought back in day of the mother of all perfect storms. For those who insist on acting as if they really are that smart, believe me, you’ll live to regret it.

I know, cuz I’ve seen me do it. :)

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{ 2 comments… read them below or add one }

Tom July 23, 2014 at 7:46 am

As always, an insightful article. My thought process typically points me to “inflation is my friend” but it is really a double edged sword.

From a cash reserve perspective, how would investors modify their strategy in today’s perfect storm of historically low interest rates paired with supply / demand? My assumption would be to increase cash reserves, but to what extent? There is always the temptation to pick up “one more” high quality asset while rates are low … but when does this go too far.

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Jeff Brown July 23, 2014 at 9:56 am

Thanks Tom — Cash reserves are crucially important, especially in ‘interesting’ times. ;)

My own cash reserves are as I advise, which is generous. I think formulas are dangerous, as an investor earning $500k/yr can often survive lower cash reserves than an equivalent investor with the same size portfolio, but making $80k/yr. My own reserves fluctuate in the $200-350k range, give or take. OldSchool is the way to go on this. Nobody ever complained that when the bovine excrement hit the whirling steel blades that they had far too much cash at the ready.

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